Chapter Outlines (doc) - Capital Structure-Value of a Firm...

Capital Structure:-Value of a Firm = PV of expected future cash flows, discounted at its WACC.-WACC depends on the % of debt & equity used by the firm; its capital structure.-The only way a decision can change a firm’s value is by affecting either cash flows or the cost of capital. Debt Increases the Cost of Stock (k s )-Debtholders have a prior claim on the cash flows than do the stockholders, who are entitled to the residual cash flow after debtholders have been paid. Debt Reduces the Taxes a Firm Pays-If cash flows are a pie, three groups get slices of the pie: first slice goes to the gov’t in the form of taxes, second to the debtholders, and third to the stockholders. -Companies can deduct interest expenses from taxable income, reducing the gov’t piece of pie and leaves more pie for Risk of Bankruptcy Increases the Cost of Debt (k d )-As debt increases, risk of bankruptcy goes up because the firm owes more – and thus has more liabilities.-Higher bankruptcy risk leads to debtholders requiring a higher return, increasing the cost of debt. Net Effect on WACC-Should be clear that changing the capital structure affects all variables in the WACC equation, it’s not easy to say whether the changes increase or decrease the WACC. Business Risk:-Return on Invested Capital measures business risk on a stand-alone basis-ROIC = NOPAT / Capital = EBIT (1 – T) / Capital-Business risk is the risk that common stockholders would face if the firm had no debt.-Business Risk depends on demand variability, sales price variability, input cost variability, ability to adjust output prices for changes in input costs, ability to develop new products, foreign risk exposure, & operating leverage.-Operating Leverage is high: implies that a small change in sales results in a large change in EBIT.-Can calculate the breakeven quantity of sales by recognizing that operating breakeven occurs when EBIT = 0.

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